Financial systems and development

so by charging fees for specific services and inter- enforcement help to reduce the risk of loss. Comest
on loans.
petition, however, is the most effective way to
The burden of costs will shift between the parties keep transaction costs low. Access to a wide range
according to the arrangements adopted. Informal of institutions and markets, including internafinancial
entrepreneurs rely on personal knowl- tional markets, stimulates competition.
edge of borrowers; their information costs are low.
In more advanced systems information and en- Government intervention
forcement become more expensive. In the early
stages of financial development, banks build the Governments intervene in the provision of financost
of gathering credit information into their cial services for many reasons. Historically, they
spreads. Later, firms supply more information on have controlled the means of payment, both to
their own behalf. A corporation issuing bonds or guarantee its soundness and to collect seigniorage.
equities must provide investors with information More recently, governments have tried to use their
about itself. Firms send audited accounts to their control of money creation to influence the level of
shareholders and to the tax authorities. They may economic activity and their control of the allocation
pay a credit rating agency to grade their securities. and pricing of credit to influence the composition
Transaction costs are also borne by depositors, of investment. (Chapter 4 discusses the recent exinvestors,
and government agencies. Depositors perience of the developing countries with policies
incur costs in visiting bank branches and waiting of this sort.) They have also intervened to ensure
in line to cash checks. Investors devote resources that financial intermediaries behave prudently.
to analyzing information. Government agencies Fractional reserve banking systems (in which
usually bear some of the costs of monitoring and banks hold only partial reserves against liabilities
enforcement. A securities and exchange commis- and lend out the rest of their deposits) have sufsion
may be called upon to certify the accuracy of fered from occasional instability, excessive risk takinformation
provided in corporate prospectuses; ing, and fraud. The liabilities issued by banks in
deposit insurance corporations may assume re- response to the demands of depositors are shortsponsibility
for monitoring deposit institutions. term, highly liquid, and supposedly low-risk.
Government agencies generally cover their costs Loans, by contrast, are usually longer-term, less
by levying fees on issued securities or collecting liquid, and riskier. This difference is one reason
premiums from insured institutions.
banks charge borrowers more than they pay de-
Spreads between borrowing and lending rates positors. But because banks are so highly
and between buying and selling prices reflect the leveraged, relatively small losses on loans can
intermediary's costs, expected loan and trading leave them unable to honor their liabilities. When
losses, reserve requirements, and taxation. Com- the public suspects that a bank is insolvent, the
mercial banks' spreads vary with the size and risk result is often a run on the bank, which sometimes
of loans. The average spread between lending spreads to other, solvent, banks. The drain of bank
rates and the cost of funds in a high-income coun- reserves causes a multiple contraction in bank
try is between 2 and 3 percentage points. In nonin- credit. When runs become widespread, as they ocflationary
developing countries, spreads are simi- casionally did in the nineteenth and early twentilar
to those in industrial countries, but because the eth centuries, financial panic can trigger a collapse
range of services offered may be more limited and of the credit-payment process and a sharp
operating procedures more cumbersome, deposi- recession.
tors' and borrowers' combined transaction costs Governments have devised ways of dealing with
may be higher. Spreads in inflationary countries bank runs. When they occurred, central bankscan
be more than 10 percent, although that reflects acting as lenders of last resort-provided liquidity
the burden of high reserve requirements as well as by rediscounting sound loans. In several hightransaction
costs. Prime borrowers may be able to income countries the government provided deacquire
funds through international markets for a posit insurance. By guaranteeing the value and lifee
as low as one-tenth of 1 percent of the amount quidity of deposits up to a certain size, deposit
raised. Although spreads tend to be narrower in insurance was designed to prevent runs from startdirect
transactions than in intermediated ones, the ing (see Box 2.5). The lender-of-last-resort facility
difference is partly offset by the additional costs was designed to prevent them from spreading.
borne by the principals.
Although prudential regulation has a different
High accounting standards and strong contract rationale than economic regulation aimed at alter-
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